Stabilization Policy and the AS/AD
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1 Stabilization Policy and the AS/AD Week 10 Vivaldo Mendes Dep. of Economics Instituto Universitário de Lisboa 25 November 2017 (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
2 Summary 1 In this chapter, we learn 2 Monetary Policy Rules and Aggregate Demand 3 The Aggregate Supply Curve 4 The AS/AD Framework 5 Macroeconomic Events in the AS/AD Framework 6 Empirical Evidence 7 Stabilization Policy and the AS/AD 8 Modern Monetary Policy 9 Required reading (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
3 I In this chapter, we learn (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
4 In this chapter, we learn In this chapter, we learn: 1 With systematic monetary policy, we can combine the IS curve and the MP curve to get an aggregate demand (AD) curve. 2 That the Phillips curve can be reinterpreted as an aggregate supply (AS) curve. 3 How the AD and AS curves represent an intuitive version of the short-run model that describes the evolution of the economy in a single graph. 4 The modern theories that underlie monetary policy. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
5 In this chapter, we learn II Monetary Policy Rules and Aggregate Demand (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
6 Monetary Policy Rules and Aggregate Demand The short-run model: three basic equations 1 The model implies that high short-run output leads to an increase in inflation... and vice versa 2 The central bank chooses how to make this trade-off by choosing the interest rate. 3 How does the CB set R t? A monetary policy rule. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
7 Monetary Policy Rules and Aggregate Demand A monetary policy rule 1 A set of instructions that determines the stance of monetary policy for a given situation that might occur in the economy 2 The rule we consider is that the stance of monetary policy depends on: current inflation and the Inflation target 3 If inflation is above the target: the real interest rate should be high 4 If inflation is below the target: the real interest rate should be low (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
8 Monetary Policy Rules and Aggregate Demand A monetary policy rule Real interest rate Long run interest rate Current inflation Inflation target Governs how aggressively monetary policy responds to inflation (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
9 Monetary Policy Rules and Aggregate Demand The AD Curve 1 Substitute the monetary policy rule into the IS curve 2 The resulting equation is the aggregate demand (AD) curve (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
10 Monetary Policy Rules and Aggregate Demand The AD curve (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
11 Monetary Policy Rules and Aggregate Demand The AD curve: main points 1 Describes how the central bank chooses short-run output based on the rate of inflation. 2 If inflation is above target: the central bank raises the interest rate to lower output below potential. 3 If inflation is below target: the central bank lowers the interest rate to increase output above potential. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
12 Monetary Policy Rules and Aggregate Demand A change in inflation (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
13 Monetary Policy Rules and Aggregate Demand A high value of m: aggressive monetary policy (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
14 Monetary Policy Rules and Aggregate Demand Shifts of the AD Curve 1 AD curve shifts to the right if: 1 Parameter ā increases 2 The target rate of inflation π increases 2 Moves to the left if... (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
15 Monetary Policy Rules and Aggregate Demand III The Aggregate Supply Curve (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
16 The Aggregate Supply Curve The aggregate supply (AS) curve is: The price-setting equation used by firmsthe Phillips curve with a new name Current inflation Inflation in last time period 1 Parameters (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
17 The Aggregate Supply Curve The aggregate supply curve (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
18 The Aggregate Supply Curve IV The AS/AD Framework (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
19 The AS/AD Framework Combining the AS and AD curve 1 Two equations 2 Two unknowns (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
20 The AS/AD Framework The Steady State 1 In the steady state: 1 the endogenous variables are constant over time 2 no shocks to the economy. 3 the inflation rate must be constant and short-run output is equal to zero 2 Steady state implies: (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
21 The AS/AD Framework The Steady State: graphically (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
22 The AS/AD Framework V Macroeconomic Events in the AS/AD Framework (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
23 Macroeconomic Events in the AS/AD Framework Event #1: An Inflation Shock 1 The economy begins in steady state and is hit with a lasting increase in the price of oil. 2 Thus, the parameter ō is positive for one period 3 The AS curve will shift up as a result. 4 Stagflation: stagnation of economic activity accompanied by inflation. 5 How? Let s see. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
24 Macroeconomic Events in the AS/AD Framework An Inflation Shock: initial response (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
25 Macroeconomic Events in the AS/AD Framework An Inflation Shock: final result It takes time to get back to the original equilibrium: inflation is sticky (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
26 Macroeconomic Events in the AS/AD Framework Event #2: Disinflation 1 Suppose the economy begins in steady state 2 Policymakers decide to lower the target rate of inflation. 3 The AD curve shifts down (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
27 Macroeconomic Events in the AS/AD Framework Disinflation: initial response (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
28 Macroeconomic Events in the AS/AD Framework Disinflation: final result (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
29 Macroeconomic Events in the AS/AD Framework Event #3: A Positive AD Shock 1 Suppose there is a temporary increase in the aggregate demand parameter ā 2 The AD curve will shift out. 3 Prices increase. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
30 Macroeconomic Events in the AS/AD Framework A Positive AD Shock: initial response (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
31 Macroeconomic Events in the AS/AD Framework A Positive AD Shock: final result (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
32 Macroeconomic Events in the AS/AD Framework A Positive AD Shock: if the shock ends (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
33 Macroeconomic Events in the AS/AD Framework A Positive AD Shock: summary (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
34 Macroeconomic Events in the AS/AD Framework VI Empirical Evidence (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
35 Empirical Evidence Predicting the Fed Funds Rate 1 The Fisher equation 2 Monetary policy rule in terms of the nominal interest rate Nominal interest rate Assume m = 1/2, r = 2%, π = 2% (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
36 Empirical Evidence Actual and predicted level for the fed funds rate (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
37 Empirical Evidence Inflation-Output Loops (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
38 Empirical Evidence Forecasts fail to predict the onset of the recession (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
39 Empirical Evidence VII Modern Monetary Policy (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
40 Inside the Federal Reserve Modern Monetary Policy: the essence 1 Central banks are now more explicit about policies and targets. 2 They react very aggressively against inflation 3 Inflation rates in industrialized countries have been well behaved for the last 25 years. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
41 Inside the Federal Reserve Low inflation (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
42 Inside the Federal Reserve More Sophisticated Monetary Policy Rules 1 Richer monetary policy rules that use short-run output create results similar to the simpler model. 2 The simple policy rule we used implicitly weights short-run output. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
43 Inside the Federal Reserve Rules versus Discretion 1 Is there any benefit to creating a systematic policy? 2 The time consistency problem: 1 Even though an agent supports a particular policy, once the future comes, they have incentives to renege on their promises 3 Firms and workers form expectations about inflation and build them into pricing decisions. 4 Resulting in no benefit to output. 5 Policymakers need to commit to not exploit inflation expectations in order to keep a low rate of inflation. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
44 Inside the Federal Reserve The Paradox of Policy and Rational Expectations 1 The goal of macroeconomic policy: 1 Full employment 2 Output at potential 3 Low, stable inflation 2 Plicymakers who do not like inflation and Rational Expectations make policy use less likely 3 Remember adaptive expectations 4 Now... Rational Expectations π e t = π t 1 π e t = π t (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
45 Inside the Federal Reserve The AS/AD Model with Rational Expectations Remember that the AS curve is given by If the Federal Reserve lowers the inflation target: The AD curve shifts down. If expectations adjust immediately and people use all information, the AS curve shifts down immediately to the new target. Inflation can be kept low without recessions. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
46 Inside the Federal Reserve Rational Expectations and costless disinflation (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
47 Inside the Federal Reserve VIII Required readings (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
48 Inside the Federal Reserve Required reading For this week you are required to read Read Chapter 13 of our adopted textbook. Charles I. Jones (2014). Macroeconomics, Third Edition, W. W. Norton & Company. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November / 48
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